A beginner's guide to investing in commodities

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Commodities are physical assets. They include metals like gold and silver, oil and gas, and so-called 'soft' commodities such as wheat, sugar and cocoa beans. Agriculture, which was traditionally hard for investors to access, also comes under the commodities umbrella. They are often called 'safe havens' as they preserve wealth in a physical way.

"Commodities are often referred to as the 'fifth' asset class, after the conventional investment asset classes of cash, fixed interest securities, equities and property," says Martin Bamford, managing director of IFA Informed Choice.

Despite recent market turbulance*, the sector has little correlation with the stockmarket and currencies, which means if equity markets fall, then the price of commodities won't necessarily plummet. Bamford adds: "They tend to behave differently to these conventional asset classes, which means they can be very useful for the purposes of diversification within an investment portfolio."

"Investment into precious metals has gained significantly greater visibility over the past decade," says Russ Koesterich, global chief investment strategist at BlackRock's exchange traded fund (ETF) arm, iShares.

"While gold has acted as a store of value for thousands of years, the recent performance of precious metals, their diversification benefits and inflationary concerns have restarted the discussion of this investment category among many institutional and private investors."

Commodity prices had rocketed over the past 10 years, with much of their success deriving from the ongoing growth story of the emerging markets. Due to an increasing population - there are now 6.94 billion people in the world, according to the United States Census Bureau - global demand is now much higher, and commodity prices had risen to reflect this.

China, as an example from the emerging markets,had impressive GDP yearly GDP growth, with its consumers richer and more numerous than ever before. They can now afford to use more oil and gas, and consume more expensive food like beef and dairy produce. Investment in urban development increased rapidly. As a result, prices for these commodities have rocketed.

Some analysts have now called an end to the commodities super cycle,  with weakening Chinese GDP growth hitting iron ore prices hard. Oil prices have also plunged, and at the beginning of October 2014, the CRB Continuous Commodity Index - made up of 17 different commodity futures - which recently crashed through key technical support.

How to invest

Some see the bearish commodity market as an opportunity to gain exposure. You can invest in commodities physically, by investing in a mining or exploration firm or indirectly through a fund or an investment trust. Investing physically means actually buying and holding the asset, although this comes with storage problems.

In the case of buying a physical asset, gold is typically the most popular, with several bullion firms offering online gold dealing and safe storage of the asset. Buying physical gold coins also offers an easy way to access the metal. The World Gold Council gives details of reputable companies on its website, so always check there first.

"Real direct exposure in commodities usually involves buying physical assets, such as gold coins or bars. This can be expensive, with buying and selling costs to consider in addition to the cost of storage and insurance. Investors will also need to ensure they buy the asset at a good price. This can be difficult to achieve, particularly when buying smaller quantities," comments Bamford.

As for other natural resources such as oil and gas, one way to access them is to buy shares in companies, such as BP (BP.), Royal Dutch Shell (RDSB) and Tullow Oil (TLW). The same applies to 'soft' commodity companies, although they are less numerous on the Footsie indices in the UK. However, your investment will be subject to movements in the stockmarket, as well as changes in the price of the commodity.

To spread risk, an investment fund is an easy way to access the sector. They also provide a degree of diversification, as they will invest in a variety of commodities.

Passive funds have also risen in popularity over the last few years, with ETFs becoming a viable way to access commodities. Equity-based commodity ETFs will invest in shares of commodity companies through an index such as the FTSE 100 (UKX), whereas exchange traded commodities (ETCs) are instruments that track the future price of the commodity, or a basket of commodities. They can either be physically-backed by the commodity itself, or use swaps with other financial institutions to provide the exposure.

However, as they only track an index such as oil futures, there is little room for manoeuvre. Should the price of the commodity fall, so will the investment, as the ETF will simply track its performance. ETCs also allow investors to 'short' or 'leverage' their investment, allowing investors to either take bets on the price falling, or the price rising.

Investors should be careful here, as although there are potential gains to be made, there could be huge potential losses too.

ETCs are available from Deutsche Bank's ETF arm, db X-trackers; iShares and ETF Securities.

Another avenue to explore is investing in a futures contract of a particular commodity. This investment will track the price of the metal, for example, at a particular point in the future, and are typically limited to large institutional investors who have the resources to take these positions. While this investment is linked more directly to the price of the metal than commodity equity funds, it might diverge from the current (spot) price of the metal because of the access costs to the future market.

What investors should be aware of

BlackRock's Koesterich highlights four reasons to invest in the sector: portfolio diversification, inflation hedge, being a safe haven and to take a bet on specific industries or regions. However, he says that investors should be aware of whether or not the investment provides exposure to the underlying metal.

In addition, commodities already make up a significant proportion of the FTSE 100. Overall, the oil and gas industry makes up 17% of the index, while basic materials makes up 13% - which translates as a large part of any UK-focused portfolio (figures correct at initial time of publishing).

Jason Witcombe, chartered financial planner at Evolve Financial Planning, advises investors to look at their current portfolio carefully before ploughing money mindlessly into the sector, as it's likely a large part will already be invested in commodities, albeit through listed commodity companies. Also, with a smaller portfolio worth £50,000 or less, such a large percentage will already be invested in the sector so it makes little sense to invest further.

Instead, for beginners with a taste for commodities, Witcombe suggests upping exposure to the emerging markets, as it is here where some real growth can be gained from commodities.

"The commodity sector is even more pronounced in the emerging markets," he says. "A large part of South America's output, for example, is very commodity-driven. Investors can put a little bit extra into emerging market equities, which are heavily weighted towards commodities."

Witcombe counsels against "jumping on the bandwagon" of rising oil prices though. "It's more speculation rather than investment, as there is no reliable return mechanism, which makes them so volatile."

Witcombe also suggests investing in the physical metal or commodity itself, or spreading risk by investing in a fund. He adds: "Keep a good focus on costs. That's why I favour tracker funds. If you are enticed to invest in a commodity fund, there can be up to a 5% initial charge. The more specialist the fund, the more you can expect to pay. If 5% is disappearing before you're started, you're on the back foot."

 

Edited 21/10/2014.